Retirement tips for early-career savers

Retirement
may seem a long way off, but the earlier you start saving,
the better off you'll be. Even skimpy savings can add up to
a mountain of cash later on, thanks to the decades it will
have to grow.

Life
goals

Taxes
& Investing

401(k) or IRA?

Asset
Allocation

Active
vs. Passive

Life goals

The financial planning
profession is undergoing a revolution, with planners migrating from a money-centered
orientation to what Certified Financial Planner Roy T. Diliberto calls "financial
life planning." The more humanistic movement focuses on what clients want to achieve
in their lifetime and helps them to reach those goals by working with them in
managing their personal finances.

Quiz people about
their financial goals and you'll get general statements about owning a home, raising
a family, providing for their children's college educations, traveling and saving
for retirement. Financial life planning puts a finer point on these goals, allowing
client and planner to build a roadmap to accomplishing them.

When you're in your 20s, it's very difficult
to make retirement savings a priority. That's because you have competing goals
for your income such as paying down student loans, buying a car, furnishing your
apartment, saving for the down payment on a house. But if your employer offers
matching contributions to a 401(k) retirement account, take up the
offer. Otherwise you're turning away free money that would help you achieve your
goals.

Money invested in your 20s has 30 to 40 years
to earn a return. Wait until your 40s to start investing for retirement and that
money only has about 20 years to grow. You'll need to put a lot more aside to
achieve the same nest egg.

This assumes that your investments earn an 8
percent average annual return in a tax-deferred retirement account.

Taxes and Investing

If
you're saving for retirement, there are a host of tax-advantaged accounts: Roth
IRAs, traditional IRAs, plus employer plans such as 401(k), Roth
401(k), 403(b)
and 457 plans. They're called tax advantaged because some are tax-deferred, such
as traditional IRAs, 401(k) and 403(b) accounts, while
others -- the Roth IRA and Roth 401(k) -- are tax-free for qualified
distributions.

Contributions to traditional IRAs,
401(k) and 403(b) plans are typically made with pre-tax
dollars and qualified distributions are taxed at ordinary income rates when the
money comes out of the account. Roth IRA and Roth 401(k) contributions
are made with after-tax dollars and qualified distributions are free of federal
income tax. Nonqualified distributions, for example, those taken before age 59½
in the case of IRAs, can result in a 10 percent penalty tax.

Take tax breaks on front or back end



What
you know: Today's tax rates



What
you don't know: Future tax rates



What
to do: Decide on an investment vehicle and get started!

Money can also be invested in taxable accounts.
It's called a taxable account because you have to pay taxes on the investment
earnings in the year that they are recognized in the account. The taxes vary depending
on whether the investment earnings are qualified dividend income, interest income,
short-term capital gain or long-term capital gain. The tax code also changes with
time, so applicable tax rates on these different types of investment earnings
can go up or down. Tax-efficient investing in a taxable account can make sense
as an alternative to retirement savings in tax-advantaged accounts.

Once
you decide on the types of accounts you will contribute to, you can work on the
investments held in these accounts. A 401(k) or 403(b)
plan typically has a limited list of investments to choose from, but other retirement
and taxable accounts don't face the same limitations. To open IRA, Roth IRA and
taxable accounts, you can choose from among banks, brokerage houses or mutual
fund firms.

401(k) or IRA?

If
your company has a 401(k) plan where the company matches a portion
of your contributions, it makes sense to contribute at least up to the limit of
the match. After that, where you put your retirement money depends on your income
level and investment goals.

Look for flexibility

You may be able to borrow from a
401(k), but not an IRA. But you can withdraw money from an IRA penalty
free in certain cases.

I'm
an advocate for financial flexibility. Unlike employer-sponsored plans, an IRA
or Roth IRA account lets you avoid the penalty tax on early distributions in certain
situations. For example, first-time home buyers can tap up to $10,000 of IRA money
for a down
payment on a home penalty free.

If you are covered
by your employer's retirement plan, then your ability to contribute tax-deferred
dollars to a traditional IRA may be limited, depending on your Modified Adjusted
Gross Income (MAGI). Your ability to contribute to a Roth IRA doesn't depend on
whether you are covered by your employer's retirement plan, but eligible contribution
limits phase out if your income exceeds a certain level.

If
you can't contribute to a Roth because your income is too high and you can't contribute
pre-tax dollars to a traditional IRA, you can contribute after-tax dollars to
a traditional IRA. It can make sense to do so because the income restrictions
on the Roth go away in 2010 and you can then convert
your traditional IRA monies on a pro-rata basis to a Roth IRA account.

The
common asset-allocation
decision among investments is between stocks, bonds and cash, or mutual funds/exchange-traded
funds (ETFs) that invest in stocks, bonds or cash. Cash is financial shorthand
for money market investments that are short-term debt securities with a final
maturity of less than one year. Bank deposits can be classified as cash if they
are held in a money market account, checking account or a short-term certificate
of deposit, or as bonds if the certificate of deposit has a maturity longer than
one year.

Your
retirement investments face two major risks: principal risk and inflation risk.
With principal risk, the risk is that your investments decline in value. Inflation
risk involves the decline of the purchasing power of your investments over time.
Conservative investors tend to be more concerned about the risk to principal,
but they should be just as concerned about purchasing power risk.

Would
you rather lose money or lose ground to inflation? Both are big risks.

A simple illustration with car prices explains
why you need to worry about both. If car prices go up by 5 percent each year,
a car that costs $30,000 today will cost $38,288 five years from now. Invest $30,000
today for five years in a CD with an after-tax yield of 4 percent and you'll have
$36,500. Your insured deposit never faced any principal risk, but you won't be
able to afford to buy the car for cash five years from now when you could have
today. Take this example out 30 to 40 years and the importance of having your
investment returns outpace inflation is magnified.

So
you shouldn't hold a lot of cash in your retirement accounts early in your career.
Choosing a specific allocation
between stocks, bonds and cash is a balancing act between the investor's tolerance
for risk and his or her investment goals.

Active vs. passive

Active
investors believe they can beat their investment benchmarks through investment
selection and/or market timing. There are a host of active strategies that include
sector rotation, value investing, momentum investing and market timing.

In an extreme example of market timing, someone
aims to invest in the stock market when it's heading higher, sitting on the sidelines
the rest of the time. The problem, of course, is that investors are generally
lousy at predicting future market movements.

A passive
investor is willing to accept average performance. Buy-and-hold investors in indexed
mutual funds or exchange traded funds (ETFs) are passive investors. Market timers
can also own index funds or ETFs, but they actively trade the shares based on
their outlook for the market.

Bond investors can try
to time the market too. When interest rates go up, bond prices go down. Active
bond investors try to avoid being "long and wrong" -- meaning they don't want
to invest in long maturities when they expect interest rates are heading higher.
They also don't want to be "short and sorry," investing in shorter maturities
only to see interest rates head lower.

Tactical asset
allocation changes the mix of assets based on what looks cheap or expensive in
the eye of the portfolio manager or investor. If stocks look expensive, then the
manager lightens up on stock exposure and adds the proceeds to either cash or
bonds.

Account fees for actively managed funds are
typically much more expensive than for indexed mutual funds. That makes it that
much harder for active managers to beat the performance of the benchmark index
net of fees.

In the early stages of investing for
retirement, a low-cost, no-load, indexed mutual fund that mirrors the holdings
of a broadly based market index is a solid investment decision.